MANAGEMENT PERSPECTIVE WHY GAS PRODUCERS SHOULD CAPE ABOUT POWER INDUSTRY DECONTROL

Jan. 2, 1995
Vinod K. Dar Chairman Jefferson Gas Systems Inc. Washington, D.C. and Senior Adviser RCG/Hagler, Bailly Inc. The business of producing and selling natural gas seems remote from deregulation and restructuring of the U.S. electricity industry. Gas producers are busy enough understanding and managing technological, capital market, and regulatory changes rippling through the gas industry to fret about what appears to be a completely different enterprise: electricity.
Vinod K. Dar
Chairman
Jefferson Gas Systems Inc.
Washington, D.C.
and Senior Adviser
RCG/Hagler, Bailly Inc.
The business of producing and selling natural gas seems remote from deregulation and restructuring of the U.S. electricity industry.

Gas producers are busy enough understanding and managing technological, capital market, and regulatory changes rippling through the gas industry to fret about what appears to be a completely different enterprise: electricity.

This is, unfortunately, an error and if not remedied could be an expensive mistake. The changes in the electricity industry over the next 5-7 years will profoundly shape the business of natural gas production.

INDUSTRY CONVERGENCE

The gas and electric industries are converging to an unprecedented and generally unrecognized-degree.

The gas industry, at $90 billion/year in final sales, is in many ways a junior cousin to the electricity industry with $200 billion/year in sales. Within 10 years we are quite likely to see an integrated gas/electric delivery system approaching $300 billion/year in revenues evolve from fragmented, separate but unequal structures that exist today.

Electricity and gas will collide at the consumer's meter and be vigorous competitors once both electricity and gas distribution are deregulated. There will be a fierce marketing battle for the energy user's dollar as unregulated merchants of gas and electricity jostle to meet the energy service needs of customers big and small.

As a result of electricity deregulation, the price of electricity at the meter will decline 15-40% depending on location and kind of consumer. Lower prices and advanced electro-technologies will create tremendous competitive advantages for electricity.

The gas merchant business will not - and cannot afford to - be passive when faced with this threat. It will respond aggressively. For the first time in memory energy retailing will become a consumer merchandising business with promotions, price wars, and thousands of services.

Electricity also will be a customer of gas at the generating plant. Gas will indeed be the fuel of choice of the deregulated electricity supply business but, unfortunately, only as long as it is cheap, with a few special exceptions.

As simultaneous friend and foe, the gas and electric industries are destined for convergence.

DEPRESSED GAS PRICES

Price pressure at the meter, surplus generation capacity, and intense competition among deregulated electric power generators, wholesalers, brokers, and traders will relentlessly drive down the price of electricity at the busbar for the foreseeable future.

There will be no rate based electric power plants in the future. These assets will be spun out of the rate base as independent companies or sold to other power producers. That will lead to creation of several enormous commodity power producing companies with $5-15 billion each in assets and two to three with more than $30 billion in assets. There will be scores of small specialty generating companies.

As a result of price pressure, commodity electricity producers will have to generate power for about 3.5/kwh, on average, to be competitive.

Because gas is such a large part of the price of gas fired generation, which is, after all, merely the process of refining gas into electricity, gas as a fuel will bear the brunt of electricity competition in wholesale markets.

State of the art new generating capacity in the U.S. will be predominantly gas fired. It will have a heat rate of at least 7,500. To produce power at 3.544/kwh, the delivered price of gas will be capped at 2.1/kwh or $2.75/MMBTU.

In general, pipelines and local distribution companies charge 50/MMBTU to move gas from wellhead to the interstate generating plant - obviously a lot less, 10-25/MMBTU, in the producing states of the Southwest. If there is no reduction in this margin, the gas producer will see prices capped at the wellhead at $22.25/MMBTU for at least a decade to come.

Once again, it may be the producer who has to do the giving, continuing the trend of the past 10 years when producers did most of the giving and very little of the taking.

In the next 10 years, electricity competition may replace competition from residual fuel, a declining factor because of air quality laws, as the new cap on gas prices just when the gas industry thought the boom in independent power production and environmental compliance was going to usher in a new era of gas as a high priced premium fuel.

In addition to megaproducers and niche power supply companies, electricity wholesalers will be consumers of gas.

Some of these power wholesalers will be "toll refineries" of natural gas, contracting with an underused or merchant gas fired power plant for its conversion capability but supplying the needed gas molecules and purchasing all the resulting electrons.

Such toll refining will be a gas/electric price arbitrage play. Both the power wholesalers and megapower producers will tend to view gas as a junk - not a prized - fuel, burning gas when it can be acquired cheaply and often not otherwise except during periods of peak electric demand.

PRODUCER RESPONSES

Gas producers can have three responses to restructuring of the electricity industry:

  • Some can declare the U.S. energy game simply too complicated and volatile, sell their domestic assets, and retire or turn their talents to international exploration and production.

  • Others can accelerate their transformation into technology driven, low cost, "methane manufacturing" companies, able to prosper at wellhead gas prices of $2/MMBTU forever.

  • Yet others can boldly but selectively integrate into the electricity business.

Methane, of course, does not merely mean natural gas in the traditional sense, nor does its delivery entail E&P only in the commonly understood way.

Coalbed methane will inevitably increase its share of Lower 48 gas deliverability in the next 20 years. Production of coalbed methane is really a manufacturing operation requiring process technology.

In many ways, production of gas from tight sands also has characteristics of manufacturing rather than traditional oil and gas exploitation.

In both instances, exploration and resource delineating costs are minor because the domestic resource is well known and the finding cost per unit of production is negligible. The value added in coalbed methane and tight sands production is almost entirely from manufacturing and processing technology.

Technology, too, is manifesting itself vitally in E&P for natural gas.

Exploration is becoming, quite decisively, a technologically sophisticated and systematic research and development activity rather than the far more romantic but decidedly more uncertain "intuitive geology" that was characteristic of natural gas exploration until the late 1980s.

Moreover, exploitation of old fields and new discoveries continues to benefit from incremental but steady advances in drilling technology and materials science. Indeed, technological advances are destroying the pernicious myths that the U.S. is played out as an oil and gas province.

There are two enduring verities in the oil and gas business:

  • Reserves are found in the mind and always have been. The mind is an inexhaustible resource. The country has been declared a dead play for decades, and yet every few years new ideas extend the frontier and the industry is reborn.

  • Some producers always have been able to make money at low gas prices, much to the amazement of their peers and disbelief of energy experts, especially on Wall Street.

The more adventurous producers can integrate forward into numerous niche markets for power generation and capture substantial margins, making their natural gas a premium fuel even though someone else's gas is reconciled to being a junk fuel.

There will be special opportunities in the power production business that are less sensitive to the price of gas. Niche supply projects will include:

  • Peaking facilities that will be able to pay $3-5/MMBTU when peak electrical loads emerge, but only episodically.

  • Generating facilities insulated from the general power grid so that electricity at 5-6/kwh is still competitive and gas even at $3/MMBTU delivered is economical.

  • On-site industrial cogeneration facilities for industrial, commercial, and institutional applications with special voltage and reliability needs

  • Small projects using long lived gas fields in the middle of an electricity market-in California, Michigan, Ohio, and New York, for example so the gas field can be tied into the electric grid through a 5,000-25,000 kw generating unit.

  • Small facilities in areas where power transmission bottlenecks create pockets of high priced electricity and debottlenecking the grid is more expensive than building a 10,000-30,000 kw gas fired generating unit.

Independent gas producers will, of course, have to be extremely knowledgeable about these niches and create internal electricity project teams to pursue them.

Market entry can be through purely contractual relationships, via coinvestment or through projects developed and owned by the 'producer depending on location, business circumstances, and technological sophistication of the project.

Major producers obviously will find large merchant power plant opportunities more intriguing because natural gas refining and gas/electric product "crack spreads" are just a low capital, less complicated analog to crude refining.

Merchant plants of 100,000-200,000 kw may not yield high gas prices but will provide very long term captive markets for large amounts of gas, fit the corporate culture and competences of the majors, and enable them to smooth out seasonality in gas demand because merchant plants, most likely, will experience high loads during the air conditioning rather than the heating season.

Neither merchant plant nor niche opportunities will materialize soon because of regulatory uncertainty.

It is in the clear interest of gas producers to understand and become active in electricity open access proceedings at the federal and state level and swiftly help create the new rules of the electricity game, one in which gas has a seat at the table.

Copyright 1995 Oil & Gas Journal. All Rights Reserved.